How changes in Index Constituents impact Index PE Ratios and PE Based Investing?

I was working on a more comprehensive P/E Ratio analysis of Nifty and Sensex when I thought about bringing this important point to everyone’s notice.

In December 2015, Sensex underwent few small changes. Two companies in the 30-share index were replaced. Adani Ports & SEZ and Asian Paints were added to the index and Hindalco and Vedanta were removed (source). I am sure that weak performance of the two outgoing companies combined with a bleak outlook for the metals sector in general, must have necessitated this change.

Now this is not unusual. The index management committee regularly reconstitutes indices to (and I guess) take index to newer heights by only allowing companies with better incremental earning potentials. 🙂

So what will happen when two low profit (or loss-making) companies are removed from the index?

By replacing these companies with profits-making ones, the total earnings of Sensex will increase. This would mean a lower PE ratio, which is calculated by dividing the total market cap of the constituent companies in the index by their total net profits.

And as we can see from table below, the immediate impact of this change was that PE came down on the day of change, inspite of index going up.

Sensex PE Ratio 2016

So this particular fall is PE is not because of fall in share prices. It is purely because the index constituents have changed and consequently, earnings have increased. For those who thought that markets have come down suddenly in valuations, this is something to make note of.

This change will also have an impact on Sensex valuations based on future earnings estimates. That is another matter the estimates are at best, estimates. 🙂

I wanted to highlight this because I regularly make references to link between returns and market PEs and how one can use this indicator to broadly assess market valuations.

Extend this concept of change in index constituents and you will realize that when comparison of index’s PE in 2016 is made with say of year 2001, then essentially, two very different indices might be getting compared.

To put it simply, the index of 2016 would be quite different from that of 2001. Sensex of yesteryears might be giving more weightage to metal and cement companies. In comparison, index of today might be more biased towards sectors like FMCG and IT. So when we compare historical PE ratios with current ones, then we need to acknowledge that we are not exactly comparing apples to apples. Due to law of averages, its also not like apple-to-orange comparison but its still not the same apples we are talking about. 🙂

Another thing that worries me is management framework of the index. I am sure that the index management committee would be doing their jobs honestly and carrying out required due diligences, when including and excluding companies in indices. But I am not sure whether there are any SEBI norms governing them or index changes.The indices traded on stock exchanges are owned (not sure) and managed by separate legal entities that do not come under the direct supervision of SEBI. I think there is a scope of increasing regulatory oversight here.


SIP on Steroids – How to give boost to your regular investments?

(Latest Update) – You can read an updated and more detailed analysis of the PE and other ratios here.

We decided to use this insight to boost our SIPs.

For our analysis, we started with SIP of Rs 5000 every month, from January 2000 and kept on investing till December 2011. A total of Rs 7.25 Lac was invested in 145 instalments. Now we add the Boost. Whenever markets PE fell below 15, an additional Rs 5000 was invested in that month i.e. a total of Rs 10,000 was invested in that particular month. This happened in 23 of the 145 months and an extra Rs 1.15 Lac boosted the normal investment of Rs 7.25 Lac. This took total investment to Rs 8.40 Lac.

So what is the current value of the investment? Did the boost help in earning higher returns? Read further. The investment of Rs 8.40 Lac stands at a Rs 23.8 Lac. And if SIP was not boosted by Rs 1.15 Lac, it would have stood at Rs 19 Lac.

In an earlier post about timing the markets, we saw that it doesn’t make sense in trying to time the markets. If earning a better-than-average return is the aim, it is enough to invest regularly in a disciplined manner rather than trying to time the markets.

Let’s suppose that you as have decided to invest at regular intervals. This type of investment can easily be executed by means of SIP or Systematic Investment Plans.

Systematic Investment Plan (SIP) allows investment in markets at regular intervals. A normal SIP invests once every month.
There are many online SIP Calculators available that can be used to calculate SIP amounts based on your financial goals.
SIP is fine…But how to put them on steroids?
Before we answer this question, we would quote an analysis from our previous post on Analysis of P/E Ratios of Indian Equity Markets. Our study suggested that whenever an investment is made with markets trading at a multiple of less than 15 (PE<15), returns over 3 and 5 years have been phenomenal.

Above data shows that on increasing our investment by 15.9% (Investing more when market is trading at lower valuations), our overall investment value increases by 25%.

So to summarize,

  • But even after discussing the benefits of regular investments in markets & redundancy trying to time the markets, if you want to time the markets by investing in direct stocks, you should stick to shares of large & stable companies (Read about how to find Large Caps selling at massive Discounts!)

Nifty Dividend Yields – A Long Term Analysis of relation between dividend yields and returns

Dividend Yield is a ratio of dividend paid last year to current market price. A further reading on Dividend Yields can be found here.
One of the two metrics used to evaluate over- or under-valuation of markets is Dividend Yield (Other is P/E Ratio). At present (Mid January 2012), Nifty has a dividend yield of 1.6 (find latest data here).
So is this a right time to invest? We at Stable Investor decided to look into index’s history to answer this question.
Analysis of Nifty’s last 13 years data (from 1st Jan 1999 onwards) reveals a few interesting points –
  • Returns during last 13 years, when segregated on basis of Dividend Yields are –
  • This clearly indicates that at current Dividend Yield of 1.6, chances of earning around 20% per annum for next 3 years are quite high! (Caution – The statement is made on basis of historical data. Past performance is no guarantee of future performance.)
  • A graph between Dividend Yields and 3-Year-Returns (CAGR) also shows that there is a high (positive) correlation between the two. Higher the dividend yield, higher the returns over 3 year periods.
Dividend Yield & Return Since 1991 [Click to Enlarge]
  • But one must understand that market does not give enough chances at higher levels. Our analysis shows that out of 2500 trading sessions in last 13 years, markets spent less than 5% (127 days) at dividend yields of more than 2.5 (which offers maximum returns over 3 year periods).
Days Spent on various Dividend Yields
So after this analysis, Stable Investor understands that though history shows that investing in markets offering high dividend yields makes more sense, one should never rely on just one mathematical tool to arrive at any investment decision. Any number should be taken with a pinch of salt and should always be looked in conjunction with other ratios and numbers.
We did a similar analysis of PE Ratios and Returns over 3 and 5 year periods and arrived at some remarkably useful results which can be found in the post Relation between PE Ratios and Returns.
If you are interested in further exploring slightly advanced topic of Effective Dividend Yield, please read our post on Dividend Investing in Indian Stocks.

Nifty Stocks and PEG Ratios

In our previous post, we saw that Indian markets are presently trading at PEG ratio of 0.97. We arrived at this figure by dividing current P/E of 16.7 by average growth rate (in last 18 years)of 17.1%.

For details, please check the post on Historical EPS Growth Rates & PEG Ratio of Indian markets.
In continuation of our analysis of PEG ratios, we calculated PEG ratios of a few Indian large cap stocks –
Click to enlarge
Some details/observations of our analysis are as follows –
  • We have chosen EPS growth rates to represent growth rates of a company. One can also use any other growth rates.
  • For each company, we have calculated 3 PEG Ratios –
    • Using latest EPS Growth Rates (2010-2011)
    • Using Average of all EPS growth rates in last 5 years
    • Using least positive EPS growth rates in last 5 years
  • Afterwards, we calculated another PEG for each company – Average PEG – which is an arithmetic average of previous three PEGs.
  • Normally, a PEG greater than 1 indicates an overvalued company, and less than 1 indicates an undervalued company. But we must understand that PEG is just a ratio and it should always be looked in conjunction with other ratios and numbers.
  • For instance, a company like Bharti has an average PEG of 0.33, which is quite an attractive number when looked at on a standalone basis. But if we consider that Bharti operates in a highly competitive industry; has loads of debt due to 3G fee payments and African expansion; has decreasing average revenues per user (ARPU) and has a negative PEG(!) for current fiscal, the number 0.33 may not look so attractive.
  • But there are also few companies like BHEL (0.59), PowerGrid (0.83), Tata Steel (0.40) and Tata Motors (0.42) which have considerable moat (competitive advantage & operations in industries having high entry barriers) and can be said to be available at good valuations. But once again, one should understand that stock like Tata Motors are rate sensitive and cyclical. And under current global circumstances, may slip further.
  • A company like Sterlite Industries (pegged by few as future RIL) is available at a ridiculous PEG of 0.19 (or 0.25, 0.08, 0.26). But that does not mean that it is going to become a future multibagger. Similarly, Maruti is available at PEG of 0.10(!)
  • Then there behemoths like SBI which may be available at outrageous mathematically calculated PEG of 6.6, but are worth investing as there current PEG stands at 0.54. But one should also consider rise in NPAs of SBI and other factors before investing.
So a Stable Investor understands that one should never rely on just one mathematical tool to arrive at any investment decision. Any number should always be looked in conjunction with other ratios and numbers.

Historical Sensex EPS Growth & PEG Ratio

How do market experts predict future index levels? It is done by estimating EPS (Earnings Per Share) of the index and then multiplying it with what they consider a logical multiple (P/E Ratio). In past 18 years, Sensex’s EPS has grown from Rs 81 to Rs 1270 (E) as show below –

As per analyst estimates, Sensex is expected to do an EPS of 1055 in FY2011 & 1270 in FY2012. This information should be taken with a pinch of salt as these are predictions. And predictions can be based on speculation. Capital Mind has an interesting post on senselessness of EPS projections.

A little calculation shows that in last 18 years, EPS has grown at 17.1%. Analysts predict that EPS for next 2 years is expected to grow at more than 20%. But considering present challenges of high inflation, high interest rates & global macro events, it seems to be a little too optimistic.

So how do we decide whether markets are fairly valuing future growth or not?

To answer this question, we use the PEG Ratio. It was popularized by Peter Lynch in his book One Up on Wall Street.

PEG Ratio is calculated as follows –


There is no hard and fast rule of which growth rate one should take. One can either take an estimate of future earnings growth or an average of the past earnings growth.

At present Sensex is trading at a multiple of 16.7 (Get latest P/E from here; For Nifty50, you can check this analysis too) and we take average EPS growth rate of 17.1% in our calculations. This gives us a PEG of 0.97 (=16.7/17.1).

So how do we interpret this number?

  • Normally, a PEG of greater than 1 indicates an overvalued company, and less than 1 indicates an undervalued company. So a PEG of 0.97 indicates that at present, Sensex is fairly valued.
  • Lower the PEG, the lesser one has to pay for each unit of future earnings growth. So, to put it simply, one should be interested in low PEG values.
  • Consider a situation where you have a stock with low P/E. Is it that the market does not like the stock? Or is it that the market has overlooked a fundamentally strong stock of good value? To figure this out, we look at the PEG ratio. Now, if the PEG ratio is big, we know that this is probably because the “earnings growth” is low & this is kind of stock that the market thinks is of not much value. Now consider another situation where the PEG ratio is small. It may be because the projected earnings must be high. We know that this is a fundamentally strong stock that market has overlooked.

But PEG is not a fool proof way valuing future growth and there are a few issues –

  • In strictest of sense, it is more of a rule of thumb rather than a formula. Reason being that the two sides of the formula have different units: you’re comparing a fraction with a percent.
  • It works well with normal values of growth rates only. For certain values, the results can be absurd. For example, it implies that a company with zero growth should sell for a P/E of 0.

An interesting but technical take on PEG Ratios can be found here. Drawbacks of PEG ratio can be found here.

Important note: You must understand that the PEG ratio relies on the projected % earnings. These earnings are not always accurate and so the PEG ratio is not always accurate. Also, being just a ratio it should be looked in conjunction with other ratios and numbers.

PE Ratio of Indian Markets – A Long Term Analysis

Price to Earnings ratio (P/E ratio) is a measure of price paid for a share relative to the profit earned by that share; i.e.

You can read more about P/E Ratios here & here.

They say that it is best to invest when valuations are low.

Sensex is currently (December 2011) trading at a P/E of 16.5. So is this the right time to invest? Is this what experts call a low valuation? We at Stable Investor have decided to answer these questions.

Analysis of Sensex’s last 12 years data (from 1stJan 1999 onwards) reveals a few interesting points –
  • Over any rolling period of 5 years in last 12 years, Sensex has not given negative returns! So if you are ready to stay invested (in this case, in an Indian Index Fund) for a period of 5 years, you won’t lose money. 
  • Returns earned during last 12 years, when segregated on basis of P/E ratios are –
Returns (Over 3 & 5 years) & P/E Ratios

This clearly indicates that at current P/E of 16.5, we have a chance of earning more than 15% per annum for next 3-5 years!

(Caution – This statement is made on basis of historical data. Past performance is no guarantee of future performance.)

So after analyzing this interesting relationship between P/E Ratio and Returns, what does a Stable Investor do?
  • Stable Investor is now in a better position to respond to people’s view that it is better to invest in markets of lower multiples (P/E). Our analysis clearly shows that if investor invests in markets of lower multiples, probability of earning high returns is very high. 
  • P/E Ratios are still relevant for judging overall valuations of markets, if not individual stocks. 
  • It is advisable to invest when markets are trading in early teens (i.e. 13<P/E<16). It has also been seen that Indian markets tend to stay between P/E Multiples of 12 and 24 (Read Indian Markets PE 12 to 24 for details) 
  • P/E Ratio is a beautiful indicator of market’s overall valuation. But before making any buy or sell decisions, an investor should also look at a lot of other information/data.
Update – You can check the latest PE-Ratio Analysis of Indian Markets in 2013 or 2012. For constant updates about Indian Markets’ PE, P/BV Ratios, please check the State of Indian Markets.